Valuation techniques for analyzing exchange traded funds are much like evaluating single stocks. A valuation focused view can help an investor make decisions and discern expected returns to help with asset allocation.
“Even the most avid proponents of passive investing estimate expected returns for various asset classes when establishing their strategic asset allocation. Active investors with more of a tactical bent are likely to rely on valuation metrics to a greater extent,” John Gabriel for Morningstar wrote. [ETFs and Tactical Asset Allocation]
Two of the most common valuation methods are relative valuation and fundamental valuation. Generally, using both methods on a single investment can be insightful.
With fundamental valuation, the discounted cash flow analysis is the basis. The value of the stock is determined by the present value of its expected future cash flows, which are discounted back at a rate that reflects the uncertainty of those cash flows. [Morningstar on How to Build a Core ETF Portfolio]
This value is then compared to the current value of the company to determine whether the company is a good investment, based on it being undervalued or overvalued.
Relative valuation is a more simple approach and can be easier. Relative valuation estimates the value of an asset by comparing the pricing of similar assets relative to a common variable like earnings, cash flows, book value, or sales. This can be a more convenient analysis and is often used as a reference point. [ETF Liquidity is More Than Trading Volume]
The analysis is called relative because the study is of one stock or ETF against another to find the relative worth and performance of companies in comparison to others, reports Investopedia. While this method is quick and easy, it can be misleading and inaccurate.
The fundamental problems of a company such as historical valuations or the business plan are left out of the comparison, but are important to the overall health of the company or ETF.
After reviewing both methods of evaluating ETFs, it is easy to see why both should be used when finding valuations. Both analysis bring relevant points to the forefront and can help avoid a foolish decision.
Tisha Guerrero contributed to this article.